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Wednesday, April 29, 2009

We learned today that the economy contracted far more than expected--6.1% on annualized basis versus and expected 4.6%-- in the first quarter of 2009. While someobservers find this continued plunge troubling, others like Jim Hamilton and Calculated Risk find some comfort that the underlying numbers are moving in a manner consistent with the economy reaching a bottom. Specifically, they note that historically consumption starts to recover in the later part of the recession even as nonresidential investment is falling--something that happened this past quarter. I hope their assessment is correct.

There are, however, reasons to be cautious. First, it may be asking too much to use past U.S. historical patterns to infer what is happening today with the U.S. economy. This is because the current recession, unlike many of the past ones, is truly global in nature and is far more pronounced than any other post-World War II global recession. Given that there are still many problems with the global economy--banking problems in Western Europe, collapse of global trade, large output gap in global economy, China's discomfort with holding dollar reserves--it would not take much (say a swine-flu pandemic?) to cause further declines in the world economy and , in turn, the U.S. economy. Second, there is still the big bank insolvency problem lurking in the United States. As discussed here and in many otherplaces, the U.S. government has yet to forcefully address this problem. (Though David Leonhardt indicates today there may be progress on this front.) It needs to be done, but at the same restructuring large parts of the banking system--that is making bank creditors take a hit--could create another severe credit crunch. Finally, there is always the chance of a deflationary spiral taking hold in the United States as U.S. domestic demand continues to collapse as seen in this figure (Click on figure to enlarge):

More declines in nominal spending like this is a sure way to let loose deflationary expectations. Although we are not there yet, Rebecca Wilder notes that in many places nominal wages are headed down. Again, I hope this past quarter was indeed the bottom, but until we know for sure Ben Bernanke needs to keep his helicopter running around the clock.

Tuesday, April 28, 2009

Steve Hanke makes the case that the Fed's misreading of the deflationary pressures in the early-to-mid 2000s caused it to overreact at the time:

One of our problems is the Fed's preoccupation with the risk of deflation. Fixated on this risk in 2002 and 2003, Greenspan pumped out dollars, cutting the Fed funds rate down to 1%. The easy credit boom continued, inflating asset prices...

What the Fed has failed to realize is that most deflations are good ones, not bad ones. During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth. If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.

Instead of lowering interest rates seven years ago, the Fed should have raised them. This would have blunted the credit boom that led to the bubble. The most visible excess was a buildup in debt relative to GDP and a deterioration of debt quality. Combined government, corporate and household debt is now 250% of annual GDP, double what it was a generation ago. A lot of the debt on both corporate assets and houses is junk. It can be repaid only by refinancing on the back of ever higher asset prices.

As readers of this blog know, I take a similarview on the deflationary pressures at that time. However, I have also argued there were a number of factors that came together--not just loose monetary policy--to create the perfect financial storm. Still, a good look at the evidence indicates the Fed's approach was highly distortionary at the time.

According to a staff report from the Federal Reserve. From the Financial Times we learn the following:

The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.

The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.

A central bank cannot cut interest rates below zero. However, the staff research suggests the Fed should maintain unconventional policies that provide stimulus roughly equivalent to an interest rate of minus 5 per cent.

Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorized at the last meeting, which included $300bn of Treasury purchases.

[...]

Still, many Fed officials expect they may well keep rates near zero for another 18 months to two years and some might see value in making this more explicit...

Wow--expanding its money creation beyond the additional $1.15 trillion and keeping interest rates at zero another 18 months. Now that is some real anti-deflationary firepower. It also makes it incredibly challenging for the Federal Reserve to reverse itself once the recovery takes holds, more so than I previously imagined. As The Economist noted in a recent article, a "messier, more political future awaits" the Federal Reserve once this crisis is over.

Monday, April 27, 2009

Yes, the government sector has taken a hit leaving the education and health services sector--okay, that is technically two sectors but I am using the BLS categories--as the only one that continues to grow. Below is a figure showing the cumulative percent change in these sectors since the start of the recession (Click on figure to enlarge):

Friday, April 24, 2009

It was not too long ago Paul Krugman was calling the United States a banana republic with nukes. Although he made this statement in jest, Simon Johnson and James Kwak have been arguing in print and on their blog that the United States has, in fact, all the characteristics of an emerging market economy with respect to its financial sector. Acording to Johnson and Kwak, the U.S. financial sector is oversized, politically influential, and as a result is preventing the necessary restructuring needed for the U.S. economy to start recovering. Martin Wolf agrees with much of their assessment:

Unquestionably, we have witnessed a massive rise in the significance of the financial sector. In 2002, the sector generated an astonishing 41 per cent of US domestic corporate profits... In 2008, US private indebtedness reached 295 per cent of gross domestic product, a record, up from 112 per cent in 1976, while financial sector debt reached 121 per cent of GDP in 2008. Average pay in the [financial] sector rose from close to the average for all industries between 1948 and 1982 to 181 per cent of it in 2007

Martin Wolf, however, questions their claim that the reason the problems in the financial sector have not be forcefully addressed is because of its political influence. I too agree the financial sector is bloated and effectively insolvent. However, I am with Martin Wolf in being skeptical of the political influence of Wall Street view. My own take on why there has been a lack of meaningful action in financial sector--mainly fixing the insolvency problems with the big banks through restructuring--is the fear of creating another systemic credit crisis.

Johnson and Kwak in their most recent blog posting direct us to this article by Desmond Lachman, someone who has spent 30+ years following emerging markets. Lachman has seen many emerging market crises and knows them well. Lachman is someone you take seriously. Here is some of the article:

Back in the spring of 1998, when Boris Yeltsin was still at Russia's helm, I led a group of global investors to Moscow to find out firsthand where the Russian economy was headed. My long career with the International Monetary Fund and on Wall Street had taken me to "emerging markets" throughout Asia, Eastern Europe and Latin America, and I thought I'd seen it all. Yet I still recall the shock I felt at a meeting in Russia's dingy Ministry of Finance, where I finally realized how a handful of young oligarchs were bringing Russia's economy to ruin in the pursuit of their own selfish interests, despite the supposed brilliance of Anatoly Chubais, Russia's economic czar at the time.

At the time, I could not imagine that anything remotely similar could happen in the United States. Indeed, I shared the American conceit that most emerging-market nations had poorly developed institutions and would do well to emulate Washington and Wall Street. These days, though, I'm hardly so confident. Many economists and analysts are worrying that the United States might go the way of Japan, which suffered a "lost decade" after its own real estate market fell apart in the early 1990s. But I'm more concerned that the United States is coming to resemble Argentina, Russia and other so-called emerging markets, both in what led us to the crisis, and in how we're trying to fix it.

[...]

The parallels between U.S. policymaking and what we see in emerging markets are clearest in how we've mishandled the banking crisis. We delude ourselves that our banks face liquidity problems, rather than deeper solvency problems, and we try to fix it all on the cheap just like any run-of-the-mill emerging market economy would try to do. And after years of lecturing Asian and Latin American leaders about the importance of consistency and transparency in sorting out financial crises, we fail on both counts: In March 2008, one investment bank, Bear Stearns, is bailed out because it is thought to be too interconnected with the rest of the banking system to fail. However, six months later, another investment bank, Lehman Brothers -- for all intents and purposes indistinguishable from Bear Stearns in its financial market inter-connectedness -- is allowed to fail, with catastrophic effects on global financial markets.

In visits to Asian capitals during the region's financial crisis in the late 1990s, I often heard Asian reformers... complain about how the incestuous relationship between governments and large Asian corporate conglomerates stymied real economic change. How fortunate, I thought then, that the United States was not similarly plagued by crony capitalism! However, watching Goldman Sachs's seeming lock on high-level U.S. Treasury jobs as well as the way that Republicans and Democrats alike tiptoed around reforming Freddie Mac and Fannie Mae -- among the largest campaign contributors to Congress -- made me wonder if the differences between the United States and the Asian economies were only a matter of degree.

Floyd Norris writing in the NY Times reminds us that the problems in the U.S. financial sector are far from over:

The loans went to borrowers who might never before have been allowed to borrow. When they found repayment difficult, they were permitted to refinance their loans, generating fees for the lenders and postponing the ultimate reckoning. Then the credit markets turned and both the borrowers and lenders were in deep trouble.

So it went with the subprime mortgage crisis. And so it is now going with corporate loans and bonds. It appears that defaults on leveraged loans and corporate bonds will soon rise to levels not seen since the Great Depression.

Read the rest here. The problems with corporate debt can be seen in the figure below which shows the difference between interest rates on BAA-rated corporate bonds and AAA-rated corporate bonds. Since the BAA-rated securities are riskier, the spread between these two yields provides a glimpse into the market's assessment of corporate risk. (Click on figure to enlarge.)

Wednesday, April 22, 2009

As a follow up to this earlier post, we learn today from the IMF (WEO, Chapter 1, Box 1.1) that there have been four global recessions in the post-World War II era and this one will probably turn out to be the worst:

To summarize, the 2009 forecasts of economic activity, if realized, would qualify this year as the most severe global recession during the postwar period. Most indicators are expected to register sharper declines than in previous episodes of global recession. In addition to its severity, this global recession also qualifies as the most synchronized, as virtually all the advanced economies and many emerging and developing economies are in recession.

Here are the numbers on the four postwar global recessions (click on figure to enlarge):

Note that in addition to the decline in output per person, there has been a sharp fall in global trade and a large pickup in global unemployment. Also from the WEO we learn why there is still the prospect of a malign deflationary cycle (click on figure to enlarge):

Monday, April 20, 2009

In my last post on the SDRs Rebecca Wilder questioned whether the SDRs will actually make a difference to the global economic imbalance problem. As a follow up to her question, I asked a friend who formerly worked at the IMF and the U.S. Department of Treasury his thoughts on the matter. Here is what he had to say (note that "Fund" is short for IMF):

This is a very long, tricky subject that I think starts with what is an SDR really? An SDR is basically a claim on another countries' reserves held via your account at the Fund. So when a country needs more USD it cashes in the SDRs at the Fund and the Fund tells the US Treasury to provide the USD. The country then runs a debit on its account at the Fund, which it pays interest, while the US gets interest on the "surplus" SDRs it has. The main point of these accounts is that some countries have hard currencies, while others (lets call them Argentina) have currencies from time to time that no one wants - so it's just a more complicated way of giving more countries access to currencies of other countries that are in demand at that time.

This doesn't really seem to me to be a workable currency yet - (1) it's not freely exchangeable in the market; (2) you can't just park reserves you accumulate in SDRs - if China has surplus USD, it can't simply go to the Fund and say I'd like to swap these for SDRs please; the IMF would have to fundamentally alter the way SDRs work to get to a system where the SDR could be usable as a reserve currency; (3) who controls the stock of SDR outstanding? When the Fund "creates" SDRs, all it is really doing is putting in place an agreement across its members to allow their currencies to be tapped by other Fund members when needed. The Fund can't grow the underlying SDRs out of thin air - every country would have to agree to put more of their currency on call. For the US , the Treasury Department would likely issue debt to raise the USD to give to a country that wants USD for its SDRs. Other countries might simply have their central banks print the money - but ultimately it's finite.

Beyond that, Rebecca's point is a decent one - if China is determined to keep its currency undervalued, then the real question is what currencies does it do so against. But that begs the question of why China would need SDRs in the first place; it could simply set an fx reserve accumulation policy of buying some USD, some EURO, some yen, and some GBP; I guess that would help the US by spreading some of china's capital outflows across more countries - and hence allow the USD to depreciate more relative to the CNY - since they would engineer a broader nominal effective depreciation.

If China's motive is more feeling the need for fx to insure against sudden capital outflows, then the Fund could help in theory. In practice it's hard since until the FCL the only way the Fund could deliver assistance was via programs which both had stigma and because they carried conditions meant that access to IMF resources wasn't automatic - so not a great way to insure yourself if you are a country; much better to have your own stockpile of USD.

A reformed SDR could play a role in this I think by being say a unit of account for parking reserves; but really the way the IMF could fulfill its function as insurer of last resort better is instead of telling a country to go run CA surpluses, accumulate a bunch of USD and bring them to us (and then what? does the Fund buy US Treasuries on China's behalf? that doesn't seem to solve any problems) is instead the Fund should act as a central clearinghouse for Central Bank fx swap lines. So when demand for a country's currency falls, it could go to the Fund and get more of the currency that demand has shifted into. Of course we go back to square one - is the country's currency falling because of unsustainable policies which require external adjustment - or is it just a temporary capital account fluctuation?

In short, the SDRs are not a panacea for the global imbalance problem.

Tuesday, April 14, 2009

Yes, I am talking about China's proposal that the IMF's special drawing rights or SDR currency be expanded and adopted as the new reserve currency. From Justin Fox we learn this idea is not original. It has been promoted for some time by C. Fred Bergsten. Here is what he had to say about it in December 2007:

There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund (IMF) through which unwanted dollars could be converted into special drawing rights (SDR)... The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid.

The fund’s members would authorize it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80 billion would more than suffice.

All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 percent dollars, 34 percent euros, 11 percent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimizing the loss on their remaining dollar holdings as well as avoiding systemic disruption.

The United States would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar...

For these reasons Justin Fox champions the SDR and argues it would be in the best interest of the United States and the rest of the world if it truly became the new reserve currency. The Economist magazine, meanwhile, explains some of the technical details of the SDR while the historian Paul Kennedy wonders if all the buzz about the SDR is just another symptom of a much larger tectonic shift in the global balance of power toward Asia.

Monday, April 13, 2009

Is the U.S. banking system insolvent? If so, the current U. S. Treasury bailout plan for banks is doomed since it is premised on the view that the banking system is facing a crisis of liquidity not solvency. PaulKrugman nicely summarizes the thinking behind the Treasury program:

The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

I find it hard to believe this is a liquidity crisis. Take one look at the balance sheet of the U.S. banking system and it is hard to escape the conclusion that the U.S. banking system is insolvent. Both NourielRoubini and Michael Pomerleano examined the banking system's balance sheet and concluded there is an insolvency problem. Here is Pomerleano:

The banking system is severely undercapitalized, with numerous insolvent banks. Clearly a more robust banking system requires far more capital and a robust loan loss reserve adding to the capital cushion. Until the trillion plus of impaired assets are removed and the banking system is recapitalized, credit flows will be restricted. In this context, it is puzzling why the administration is tinkering at the fringes with programs designed to enrich Wall Street. Geithner and Summers need to address the banking problems square-on.

So what exactly does the U.S. banking systems balance sheet look like? Thankfully, Tyler Durden at Zero Hedge went to the trouble of creating a consolidated balance sheet for the U.S. banking system for 2008:Q2. As Felix Salmon notes, the numbers from this balance sheet are "terrifying." I have posted a picture of the balance sheet below. (Click on the figure to enlarge.)

Tyler explains the gravity of the situation as seen in this balance sheet:

The biggest concern is the roughly $8.1 trillion in loans currently on the asset side of the equation, however the other assets, which include $2.8 trillion in securities and $2.5 trillion in other assets should not be ignored. I point out the loans as this is where the vast majority of the "toxic assets" reside. The real question mark is what is the true value of this $8.1 trillion number as the financial system contracts massively. As has been pointed out, banks have taken only about $1.2 trillion in write downs against these assets.

Is that amount of write downs enough?

Not by a long shot if one considers the various guarantee and support programs enacted by the Federal Reserve and the Treasury. In a normal world, the Assets, by definition, should equal the Liabilities plus Shareholder Equity. As nobody knows what the true value of the assets really is, the Bail Out support programs are designed to provide the backing to make it seem like the almost $8 trillion in deposits, the core of bank and thrift liabilities, are not "supported" by toxic assets, or "hot air" to use popular jargon. As presented, the various Bail Out programs now support over 72% of the total liabilities on the balance sheet. The implications of this are staggering: Roubini anticipates the total amount of write downs (in the US) will reach $3.6 trillion, or another $2.4 trillion to go. The revised IMF estimate (which is not the final one by a long shot) estimates $3.1 trillion in total US losses, or another roughly $2 trillion to go. These provisions are optimistic. Why - because through its various implicit and explicit guarantees the administration is saying the total pain could potentially reach $8.8 trillion.

According to Tyler, then, there is only about $1.4 trillion in bank capital with potential write downs ranging from $3 trillion t0 almost almost $9 trillion. That spells an insolvent U.S. banking system. It is also striking that 72% of the liabilities in the U.S. banking system are being supported by the government. With so much existing government support how much different would outright nationalization be? The only downside I can see is that a restructuring of the U.S. banking system could trigger another credit crisis. But either way there is some cost. I say we take the hit now and restructure the banks.

Many observers, including myself, have questioned whether the Fed has the will to reverse the expansion of its balance sheet--the projected $2 trillion plus increase in the monetary base--once the economy starts recovering. While this monetary expansion is necessary now, a failure to reverse it in the future could lead to 1970s-type inflationary pressures. To do so, though, requires a large contraction of the monetary base--whose expansion has largely taken the form of a buildup in banks' excess reserves--which could knock the economic recovery down just as it is getting started. John Taylor, among others, is not convinced the Fed will be able to make such a politically unpopular move.

Via Mark Thoma, we now learn that Susan Woodward and Bob Hall believe this concern is misplaced. They argue in an almost upbeat manner that there is a "simple and effective answer" to this dilemma:

The Fed should raise the rate its pays on reserves as needed to control economic activity and inflation. It is unnecessary for the Fed to cut its reserves to low levels once the economy approaches normal conditions. Rather, it only needs to raise the reserve interest rate to a point sufficiently close to market rates to make banks willing to hold excess reserves.

While this approach may be simple, I am not so sure that it is effective since it implies a potentially large fiscal cost. As the economy recovers, market interest rates will go up and necessitate that the rate the Fed pays on excess reserves also goes up. Given the large stock of excess reserves, the interest payment could turn large. How would the Fed pay for it? The Fed could keep more of its seigniorage, but that would mean less revenue for the federal government. This would be, then, another implicit fiscal cost where banks would be funded by taxpayers.

Once the economy begins to recover I see four potential paths the Fed could take with regards to the large buildup of excess reserves:

The Fed could do nothing and allow the inflationary pressures to emerge.

The Fed could reverse the buildup of excess reserves and in the process stall the economic recovery.

The Fed could pay even higher rates on the excess reserves and potentially incur large fiscal costs.

The Fed could pray for super-robust economic growth that would allow the economy to quickly grow (i.e. increase real money demand) into the money supply. This would be the cure all solution--no need to reign in the buildup of excess reserves and no need to worry about inflation.

Number (4) is pipe dream. I suspect some combination of numbers (1) and (2) will be the likely outcome. Note that if the Fed pulls a Paul Volker and focuses solely on number (2) it would not only stall the economic recovery but may also incur some fiscal costs. This is because the Fed could have a negative equity position on its balance sheet by that time--interest rates will eventually go up and, in turn, push down the prices on securities currently held by the Fed--that would require it to either borrow securities from the Treasury or issue its own debt in order to reign in the expanded monetary base. The bottom line is there are no easy options ahead for the Fed once the recovery begins.

Tuesday, April 7, 2009

Going beyond the headline numbers, two recent articles shed some light on the severity of the current recession. First, the New York Times reports the following:

As the recession grinds on, more and more of the nation’s means of production — its workers, its factories, its retail outlets, its freight lines, its bank lending, even its new inventions — are being mothballed.

This idled capacity, like baseball players after a winter off, takes time to bring back into robust use. So even if the recession miraculously ended tomorrow, economists estimate that at least three years would pass before full employment returned and output rose enough for the economy to operate at full throttle. [emphasis added]

Next, Barry Eichengreen and Kevin H. O'Rouke look at the global economy and conclude that current recession to date is actually as bad or worse than the early part of the Great Depression:

The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices...

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

[...]

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations... The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event.

Here are the key figures from their article (click on figures to enlarge):

The authors, however, note that economic policies today are far more proactive in tackling this crisis than in the 1930s. The only question is whether the new policies will mater. I hope they do or we may have to wait a while before we can begin our 3-year journey to full employment.

First, I really liked Mark Thoma's take on what caused the financial crisis. While acknowledging the role the Fed played, he contends no one factor is entirely responsible for the current crisis. Rather, this economic debacle is the result of a perfect storm of developments coming together at just the right time. This is a view I have come to adopt--early on I tended to put too much emphasis on the Fed--in my thinking.

Second, I was really glad to see Mark and Scott discuss nominal income targeting as an alternative way to conduct monetary policy. This approach makes the most sense to me because it is capable of handling both aggregate demand and aggregate supply shocks--something that cannot be said for inflation targeting. As I noted earlier:

Such a [nominal income targeting] rule would (1) force the Fed to be more vigilant in stabilizing nominal spending while (2) allowing it to avoid the distraction of rigidly following inflation. Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call.

I would also note that one of the critiques of such a rule is that it would be difficult to implement in practice since GDP numbers come out so infrequently. My reply to this critique is that there are just as severe problems in implementing an inflation targeting rule like the Taylor rule. Here, ones needs to know the elusive output gap and the neutral interest rate. With a nominal income targeting rule, however, one could in principle use monthly indicators for nominal GDP--coincident indicator and CPI--to estimate the nominal GDP on a monthly basis. Moreover, Scott mentioned an even better solution: set up a futures market for nominal GDP. This would allow for a forward looking nominal income targeting rule.

Thanks Mark and Scott for a great discussion.

Update:here is a nice introductory article on nominal income targeting from the St. Louis Federal Reserve.